Common justifications for the use of the letter of credit fail to explain its widespread use. The classic explanation claims that the letter of credit provides an effective assurance of payment from a financially responsible third party. In that story, the seller – a Taiwanese clothing manufacturer, for example – fears that the overseas buyer – Wal-Mart – will refuse to pay once the goods have been shipped. Cross-border transactions magnify the concern, because the difficulties of litigating in a distant forum will hinder the manufacturer's efforts to force the distant buyer to pay. The manufacturer-seller solves that problem by obtaining a letter of credit from a reputable bank. A reputable bank is unlikely to default on its obligation to pay the seller, and the seller knows that it has an absolute right to payment once it ships the goods – conditioned only on the seller's presentation to the bank of the specified documents (typically the invoice, a packing list, an insurance certificate, and a transport document such as a bill of lading). Thus, the story goes, the seller that obtains a letter of credit can rest assured that it will be paid even if the buyer would not pay voluntarily.
The payment-assurance story is logical and plausible. But it rests on a line of reasoning that is largely untrue at one important and critical point: the seller's possession of an absolute right to payment. When I spoke anecdotally to bankers and lawyers familiar with the industry, they uniformly claimed that sellers ordinarily do not present documents that conform to the requirements of the letter of credit. Among other things, documents might be missing, late, or fail to precisely match the details about the shipment provided in the letter of credit.
Under the standard payment-assurance account, the whole transaction hinges on the seller having a reliable right to payment by the bank that issues the letter of credit. But if the seller often does not submit documents that conform to the letter of credit, then the seller has no right to payment at all, just a request for a payment that will be honored only if the buyer waives the defects in the seller's presentation. And if the seller's ability to collect rests on the buyer's unconstrained choice to waive defects in the seller's presentation, then why buy the letter of credit instead of the simpler (and presumably cheaper) course of shipping the goods and simply waiting for payment from the buyer? That parties to a sale transaction would ignore formal documentation requirements is not surprising, but their systematic purchase of a product conditioned on their compliance with requirements they commonly ignore does not appear rational.
Banking and Finance Law | Business Organizations Law | Law
Center for Contract and Economic Organization
The Charles Evans Gerber Transactional Studies Center
Ronald J. Mann,
The Role of Letters of Credit in Payment Transactions,
Mich. L. Rev.
Available at: https://scholarship.law.columbia.edu/faculty_scholarship/454